Crisis in Europe, Transformation in China

Chinese leaders know that, with Europe and the U.S. struggling, they can't rely on exports forever. China's future may hinge on whether its leaders can make the necessary changes in time.

A 1979 poster promotes China's steel industry / AP

"I
want to remind those cadres who are staying on the job beyond me: my
biggest worry right now is an overheating economy," Chinese Premier Zhu
Rongji said in a January 2003 cabinet meeting, his last before leaving
office. "I've already worried about this for a year now. I wouldn't say
this publicly, but only bring it up to the top leadership, that
overheating is the one thing that preoccupies my mind. Many signs seem
to have emerged, and if we're not vigilant, the economic situation will
be difficult to rein in." Zhu's comments, recently published for the
first time, are translated to English here.

The next premier, Wen Jiabao, warned in 2007
that China's economic model of skyrocketing export-based growth was
"unstable, unbalanced, uncoordinated and ultimately unsustainable."
Fortunately, he and his government seem to know how to fix it. But the
question isn't whether China's economy can accommodate the necessary
changes. It almost certainly can. The big question is whether China's
political system can accommodate those changes. If it can't, Chinese
citizens may begin to more aggressively question the Communist Party's
model of rule, which delivers tremendous economic growth at the cost of
political and human rights.

When they issued their calls for
change, neither Zhu nor Wen could have possibly foreseen the financial
crises that have crippled the U.S. and European economies. Though
China's leaders have long planned to change the country's economic model
-- which is also at the heart of its political model -- these crises
mean that China must accelerate its plan to restructure its economy.
Right now, China's economy is based on exporting to wealthy, developed
countries. For that export-driven system to work, China's economy needs
to remain weaker than those of its buyers. One of the biggest reasons
that China sells so much stuff is because it can produce that stuff
cheaply. But as China's growth accelerates and European and American
growth slows due to financial crises, China is catching up with the
developed economies faster than anyone had anticipated. If and when
China gets too wealthy to continue exporting cheap products -- or if the
developed economies become too weak to keep buying them -- it will be
in big trouble.

China will have to shift
its economic emphasis from exports -- driven by state-run industrial
enterprises -- to individual households. This means moving wealth from
the state and state-run companies to Chinese households, which would
then drive China's continued growth. This is feasible -- China has
nearly 1.5 billion consumers, after all, an increasing number of whom
are entering the middle class, where they will be willing and able to
power the economy. This wouldn't be so different from how the U.S.
economy became the largest in the world: our consumer base is big, rich,
and it loves to shop.

"It's true that Chinese authorities are
hotly discussing how and whether they can move away from the
export-dependent model of development," colleague James Fallows wrote in
an email when I asked him about how China was handling the worsening
European crises. "But this has been the main topic of discussion for at
least three years, and the real question is whether they can do so, and
how, and over what period of time. For outsiders the real question is
whether there is anything the rest of the world can do to hasten the
process."

The timeline for how quickly China needs to restructure
its economy appears to be shortening, and not just because of the
ever-expanding European debt crises. Housing authorities just capped real estate prices in a second city to try and prevent a housing bubble, informal lending markets are booming, export growth is already slowing ahead of expectations, and the gap between mainland China's managed currency rate and Hong Kong's floating currency rate is expanding.
China doesn't appear to be anywhere near financial calamity or anything
like it, but the urgency for China to change its economic model is
increasing.

The changes that China's leadership knows it needs
aren't just about making Chinese households better off and finding a way
to responsibly manage overall growth. They're about maintaining the
very stability of the Chinese system. In a democracy, if people feel
their government has failed them then they can vote that government out
of office. But in an autocracy like China's, popular discontent can be
more dangerous. Demonstrations, some of them violent, have already
broken out in a number of interior cities this year. Last month, a young
man lit himself on fire in Tienanmen Square, an eery echo of the self-immolation that set off Tunisia's revolution in December.

China
has remained largely stable since 1989 for a number of reasons, perhaps
the most important of which are its ever-rising economy (which gives
Chinese good reason to be happy with their government) and, to a lesser
extent, China's ability to prevent and stifle dissent. It's a
carrot-and-stick approach. But the Chinese government knows it can't
maintain power through censorship, propaganda, and riot police alone.
They need to keep growing to keep Chinese citizens happy, but they also
need to slow that growth down to keep the economy healthy in the
long-term.

This is a difficult balance, but not an impossible one by any means. Michael Pettis explains how and why it's achievable. And Chinese leaders seem to understand what they need to do. But as Damien Ma recently wrote,
"It's not that the Chinese leaders don't get what's at stake -- they
know such a reckoning must be had. But recognizing what must be done is
quite different from summoning the political chutzpah to achieve it." If
Chinese leaders want to continue to behave as disinterested and
benevolent rules, and make the necessary but difficult changes, they'll
have to overcome the same problem that partially inspired the recent
"Occupy Wall Street" protests in the U.S.: industrial capture.

China's
growth has created some very powerful industries and interests in the
country. The firms that made a lot of money became politically
connected, and vice-versa. Think of how much of a problem the coziness
between business and government has become in the U.S., making it
tougher for the U.S. government to regulate industry and to not be
overly influenced by commercial interests that might conflict with the
greater good. And that's just in the United States, which has a
(relatively) free market economy with a (relatively) transparent and
democratic political system. Imagine how much more influence American
corporations would have over our government if we had a closed autocracy
that partially ran our industries and you can get a sense of the scale
of China's potential problem. The Chinese firms that rose with China are
going to want to resist change -- even changes that might be beneficial
to China overall -- and now they've got the political connections to
make that possible.

In the Eurasia Group's lengthy report
on China's new Five-Year Plan, they warn that Chinese Community Party
will have to overcome some deeply entrenched financial interests to make
the necessary changes. Their prediction is severe: "China's leadership
will fail to introduce the bold reforms necessary to meaningfully
redistribute wealth from corporations and government to households. For
instance, big state-owned firms will fiercely resist contributing large
chunks of their dividends to government social security funds."

But
the same tendency to intervene in the economy, particularly in China's
financial system, could well set up a battle over capital allocation and
investment decisions, in which powerful stakeholders will resist any
attempt to transfer wealth to new constituencies. And China's leaders
are unlikely to deal with these powerful "losing" interest groups
holistically. Nor is a strongman or tightly knit group of leaders likely
to be able to overcome them. Ultimately, then, China's political
environment will defeat many elements of the FYP. Without significant
changes to governance structures--and to the role the state plays in
capital allocation--China's economic landscape will not change as
fundamentally as the FYP's designers (and many foreigners) hope.

...
The senior political leadership is not receptive to reforms that would
weaken the Chinese Communist Party's power over the financial system and
thus jeopardize its ability to bankroll massive industrial policy
spending on powerful constituencies, which constitutes another major
12th FYP priority. Given this discord, Beijing is unlikely to articulate
or pursue a convincing plan for remedying the financial sector's most
glaring inefficiencies over the next five years.

The
report warns that the Chinese Communist Party could endanger the very
stability of Chinese politics if they fail to implement the needed
reforms. "China's rebalancing agenda is not merely about economics but,
ultimately, the political viability of the Chinese system. Beijing has
delivered economic prosperity to many Chinese citizens. But those very
successes have yielded numerous problems--some large--that could undermine
the regime's legitimacy if left wholly unattended," they conclude.
"That income and development gap is unsustainable both economically and
politically."

One of the immediate issues will be, as in the
U.S., jobs for grads. "Disenchanted graduates earning only slightly more
than migrant workers will be a source of significant political pressure
and Beijing will intensify its efforts to employ them," the Eurasia
Group report warns. "Meanwhile, as Chinese workers' expectations rise,
Beijing will continue grappling with demands for better working
conditions and representation, even as the country tries to remain an
attractive investment destination." While China remains politically
stable -- stabler than a number of European democracies -- dissent and
protest are increasing.
Government censorship and repression -- including through violence --
are also increasing. China's autocratic government, though a frequent
and severe human rights abuser, is still relatively open and stable for
an autocracy. If it's going to stay that way, the Chinese Communist
Party will need to make some significant changes to the country's
economy.